Like many small business owners, Jenny Dibble relies on independent contractors. Sometimes the subcontractors outnumber the eight full-time employees at her interactive marketing company, SearchMarketMe, in Issaquah, Washington.
Which is why she’s concerned about a new IRS initiative. Recently, the agency enacted a plan to audit 6,000 more businesses over the next three years, and misclassification of employees as contractors is one of the primary targets. Couple that with the Obama administration’s 2011 budget proposal allotting $25 million to hire 100 auditors in an effort to generate an additional $7 billion in tax collections over the next decade, and business owners like Dibble have reason to worry.
The number of independent contractors, sometimes called 1099 workers after the IRS income reporting form, has risen sharply since the beginning of the recession. To trim overhead costs, employers often replace full-time workers with contractors, and it’s easy to see why: Independent contractors can decrease payroll costs by as much as 30 percent.
To get that advantage, employers must be able to show that workers meet a number of conditions, such as setting their own schedules, using their own tools, and not working at the employer’s location. But the IRS suspects that many employers have been cheating at this game, and that misclassified employees have, in turn, been taking too many deductions and reducing their net income to pay as little tax as possible. The stepped-up audit activity is an effort to increase tax revenue from both sides.
Unfortunately, the effort is likely to hit small and new companies the hardest. “The way many businesses start is by using contractors,” explains Marina Tsatalis, an employment lawyer at Wilson, Sonsini, Goodrich and Rosati in New York. Bigger, more established businesses have had more time to develop systems for making sure contractors are classified correctly, she says, and many have already been audited, so they know the rules and costs of not complying.
Those costs can add up quickly, because when an employee is found to have been misclassified, the employer will have to fork over back taxes as well as penalties.
Other taxing entities, including budget-strapped states, are also going after contractor misclassification. While state tax rates are lower than federal rates, the chances of having to pay are often greater because state auditors tend to be more inflexible, says Bill Smith, a tax attorney and director of the national tax office for business consulting firm CBIZ MHM in Bethesda, Maryland. “In many states, you don’t have the equivalent opportunities to contest a proposed tax increase that you have with the IRS,” he says. “As a result, states can be very draconian in their enforcement; they tend to rely more on the findings of their auditors.”
In the past couple decades, the IRS has spent less time auditing independent contractors, mostly because funding for the activity dried up under previous administrations. Audit rates in recent years had declined to the 1 percent to 3 percent range, Smith says. Now, audit and enforcement activity is returning to levels experienced in previous prolonged economic downturns.
The high rates of return that cash-hungry federal and state tax collectors expect for investments in auditing will drive even more enforcement. “I think it’s going to get worse and worse,” Smith says.
While businesses that continue using contractors will find themselves at higher risk of an audit, that doesn’t mean they’ll stop using contractors. Dibble, for one, has no intention of using fewer subcontractors as her business grows. To avoid trouble, she has contractors sign a contract stipulating that they are independent workers, and even has them form their own corporations. Says Dibble, “It takes a lot of the question out of the IRS rules on 1099 workers.”
To understand the laws governing independent contractors, and to ensure you’re classifying employees and contractors correctly, see the following articles: